Replacement Reserve Funds

I have a question about reserve amounts. When analyzing deals, what do you budget for reserves? do you withhold a flat rate amount, or do you withhold a percentage of the gross rent? Currently I am using a 10% of gross rent for my calculations. Is that too much, is it not enough? Does your market make a difference in what you reserve? I am in the dfw market, specifically fort worth. Thanks in advance.

I guess it depends on how many you have and how much income the ones you have are generating.

I really think you need to look at reserves as a sliding scale.If you own between 1 to 5 - I think you need about 5k per house.Between 6 to 10 - About 3,500 per house (i.e. 20k for 6 houses is good, 35k for 10 houses is fair).Between 11 to 15 - 3k per houseAnd 16 to 20 - 40k in the bank should be sufficient.20 or more - 50k should do it.

That also assumes that you should net about 200 to 300 per house or more on average.

So technically, if you have 20 houses, you should be making about 4 to 6k net profit (after vacancies and basic repairs). Then if you have a roof or a couple of hvacs go out in one month, you would use your profits to cover those and shouldn't have to dip into your reserves at all. If you really get hit hard one month, then you might have to dip in. But then the next month you should be able to replenish your reserves from your profits.

I really believe that the hardest time I had was early on when I only had a couple of houses. A vacancy really hurt. An eviction (2 months plus attorney fees - luckily I didn't have any cook county evictions back then) kept me up at night... :-)

The one thing I will say is that I had very few major mechanical issues back then. For the most part, I was buying houses with decent hvac systems. If they didn't have decent hvac systems, roofs, etc, I was budgeting enough of a rehab to replace them.

And I rarely have had to replace a water heater - mostly because I tend to replace them automatically in every single rehab I do. I just figure they've been sitting for over a year and the towns down by me can have kind of shaky water so the water heaters are that much more likely to have issues.

$650 for a new water heater = no late night calls of flooding.Water and hvac are 2 of the 3 items that can generate an emergency call.

I use 10% gross rent per month as my calculation for maint/reserves when looking at properties. Once I hit a predetermined amount of reserves as others have suggested above, then the excess money goes to other things. Either cash for next purchase or pay down mortgage. Whichever makes you sleep better at night.

Do you keep a separate amount for repairs and reserve or just lump it together in the 10%? I had been doing a 10% repair sinking fund and a 10% reserve for vacancy. Probably overkill to have both and it definitely eats into the cash flow.

On another forum, the suggestion was to amortize the individual items that might need replacement, such as water heaters, dishwashers, a roof, etc. For instance, if a roof is going to cost you $4000, and you think you can get another 10 years out of it, put away $400 per year. Water heater should last you 10, so put away 1/10 of the cost of a new water heater per year.

Does this formula work in reality? One potential problem I could see is that the difficulty in forecasting when stuff would break. Does it make sense to stick with a flat figure of $3k-5k per property instead of contributing a little bit each month and letting the cash build up?

On second thought, does it really matter how much cash you have sitting around, if you have the capacity to fix things? If you have $5k in a reserve account, but what happens when by some odd coincidence every appliance in the house dies in a six month span, the tenant vacates and it just so happens the carpet is 8 years old an needs replacing before it can be turned over, and the entire place needs a new paint job. It would appear to me that flexibility would be more important than fixed numbers, and your Home Depot, Lowes or Sears credit card may be your best friend.

Now, you just have to decide how you want to set up "operational" reserves; that is the money you set aside for paying taxes, insurance, utilities, mortgages, evictions, etc (normally operating expenses) when you are experiencing an "economic" vacancy (no rent coming in whether you have a tenant or not).

I lean towards the more conservative end of the spectrum ... I look at it from the perspective of needing reserves for several purposes:

Operational Reserves - PITI of 6 months (lenders will count easily accessible funds such as IRAs, but I prefer cash in the bank).

CapEx Reserves - The spreadsheet approach listing out items of property (roof, etc.) with remaining life is a great way to look at it. One tip on this ... if you live in a community with an HOA you can look at the HOA reserve study to see get an idea. For example, I live in a townhome so our HOA reserves cover common parking areas, roofs, etc. It won't give you reserve amounts for items the property owner is responsible for (HVAC, etc) but it will give you a good idea of replacement costs and expected life of various items of property. In NC an HOA probably paid ~$5k for a professional reserve study done by knowledgeable professionals (civil engineers), so it's worth taking advantage of the information in the reserve study. It will typically include the expected price inflation by category ... for example, roof replacement costs might be going up 5% per year while paving is only going up 1.5% per year.

@Tom DupreeThanks for that wonderful tip. I never would have thought to examine the HOA reserve study. I don't have an HOA where I live, but I may ask some friends to look into theirs for me. Thank you again for that great tip!

Hey @Marlon Freeman - I have been working on that exact question as well since our portfolio has grown. I am totally with @Tom Dupree and am far more conservative. We have 10 doors in two very expensive areas (SF bay area and seattle). I personally like to keep about 1 month's expenses for the entire portfolio sitting in checking, just to make sure I never bounce anything / have space for surprises.

In addition to that, I keep 3 months of fixed & est. variable expenses + whatever my reserve study requires (http://cl.ly/image/1G3n2P0s3Y3p). Note that I don't include vacancy and also have an avg maintenance budget independent from capital improvements. That is just the cost of small day to day repairs from wear and tear.

The reserve study is a new idea to me as well and I am just trying to map that out right now. I am messing with the way my reserve study feeds into the spreadsheet as I need to limit it to my hold time (http://cl.ly/image/1b0r2q3j2a41). No point in saving up for a roof that expired in 15 years if I am planning a 5 year hold. I also need to fill in the cost for all these items.

You'd need to take into consideration when they were built; however, most buildings aren't new - why the standard appraisers/lenders has not been updated, I do not know. Perhaps they aren't accounting for our "non"-inflation where prices on everything else are increasing. I add ~3.5% in PNW area for inflationary figures to all my Y/Y expense figures.

@Zach Schwarzmiller thanks for that tid bit of information. I like the idea of accounting for inflation. I suppose if i use a percentage of income to set aside, then in my rental increases the cost of inflation is automatically covered.

@Justin Case that seems more like coverage for your personal expenses.

Replacement Reserves are different than loan servicing reserves. As @Steve Babiak pointed out (links provided above), we've found that the most complete "resource" for replacement reserves has already been put together for us.

For me, a big part of the exerecise is to walk a newly acquired property and identify useful life of systems and appliances so that you can adequately fund your initial reserve. All this is to perpare for the inevitable (when something fails) and to make sure you are not caught short on funds. See the "Replacement Reserve Schedule" part of the form. If you choose not to fund the reserve account, then at least you know your exposure. My company literally transfers amounts weekly (automated transfer) from the company operating account into the separate reserve account as part of our reserve implementation.

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